Breaking up is hard to do

General dissolutions of legal practice partnerships involve, at best, a laborious and usually expensive administrative process, otherwise known as winding-up. Files have to be dealt with, offices cleared, client account money returned, debts collected and creditors paid. The business and goodwill are not normally sold off. Instead, the goodwill evaporates, or parts of it are taken, by agreement or otherwise, by partners to their new firms. That is in contrast to technical dissolutions, which occur on a sale or merger of a practice, and do not involve winding-up.

The solicitors' profession tends to be susceptible to general dissolution, probably more so than other professions, and certainly more so than trading partnerships. There are a number of reasons for this.

It is no accident that the facilitators of legal practice mergers are usually recruitment consultants who are selling primarily the partners and the goodwill, with the staff and any other assets usually being regarded as ancillary.

In contrast, in the market in trading partnerships, the facilitators are often surveyors or estate agents who might typically be selling primarily the trading premises with the business run from those premises and the staff, but not the partners.

In professions other than the solicitors' profession, goodwill often attaches more to the practice than to the individuals, making the practice more readily saleable.

Since the strength of a legal practice's goodwill, and the ability to repeat the historic turnover, can often depend so much on the personal relationship between the principals and their clients, it is not surprising that acquiring firms want to put each of the partners under a microscope, not only in respect of their client connections, but also their all-round abilities. The temptation to cherry-pick partners and their clients rather than take the entire firm is aggravated by the succession rules common to all solicitors' professional indemnity policies by virtue of the Solicitors Indemnity Insurance Rules (in particular, the definition of 'successor practice' in appendix 1).

It only takes one of the following conditions to be satisfied before a legal practice (B) is deemed to succeed to the prior practice (and thus to the obligation to insure the ongoing potential liabilities) of a ceased practice (A), with an almost inevitable and possibly unacceptably large hike in premium:

B is held out as the successor of or incorporating A;

sole practitioner A becomes a principal or employee of B;

the majority of the principals of A become principals in B;

where no majority of the principals of A have joined another practice, one or more principals of A have joined B, and: B is carried on in the same name as A or incorporates at least a substantial part of A's name; B is carried on from the same premises as A was; B acquired the goodwill of A; B assumed the liabilities of A; and/or the majority of staff employed by A became employees of B.

Another reason why a legal practice may cease without merger or sale is that the partners may fall out with one another, so that disposal of the practice as a going concern is impossible. In my experience, solicitors top the league for partnership disputes among the professions.

Thus it is that partners of a legal practice who are ceasing to trade often find themselves unable to sell the firm or bolt it onto another firm. Accordingly, the partners end up scattered among several different firms, but still reluctantly carry between them the husk of their old legal practice, which has to be wound up by them (unless they pay someone else to do it - but even then there are certain responsibilities, including those involving client money, which cannot be delegated, at least not outside the profession).

In most cases, on the winding-up of a professional firm, the balance sheet value of almost every asset (apart from cash) is overstated. Leases, previously stated as assets, become burdensome liabilities until assigned or (at a cost) surrendered. The terms of hire of some office machinery, such as photocopiers, usually provide for severe (but lawful) penalties on early termination of the contract. Certain fixed assets, such as new office furniture, computer systems and software, and fitting out, though stated at acquisition value less any annual depreciation, in reality have little or no value.

Work in progress may, in many cases, belie the value of bills that can actually be rendered. Sometimes work in progress ends up being billed in partners' new firms and may not be fully accounted for. Clients with outstanding bills may see the demise of the firm as an opportunity to avoid paying, and compromises involving lower amounts may have to be reached.

In addition, the firm or its partners face new or accelerated liabilities. Staff members who do not leave of their own accord may be entitled to a redundancy payment. The bank will want the partners to pay back their capital loans (usually dissolution is an event that triggers an obligation to repay), which they may be unable to do, not least as all of the dissolved firm's cash is being used to discharge liabilities as quickly as it is collected, and there is likely to be a shortfall at the end of the day, in any case.

Pending repayment, the bank will require interest to be covered, but Revenue & Customs will not allow such interest to be set against earnings when calculating income tax and, in addition, the partners may need to raise fresh capital to be injected into their new firms.

There may be a firm's overdraft, in addition to the partners' individual capital loans, which will also generate interest charges. Depending on how fast debts can be collected, the overdraft facility may be needed for some time. The bank may see the dissolution as an opportunity to offer a new facility, for which there will be a facility charge, and this charge may recur periodically.

Dissolution normally gives rise to acceleration of liability for income tax (resulting in two years' tax being payable at once), subject to the mitigating effect of overlap relief (the return of any double taxation paid on start-up or joining the practice).

In a legal practice, if there is no successor practice, the partners are obliged to purchase run-off indemnity insurance for six years, typically at a cost of two-and-a-half times the last annual premium. If a practice ceases midway through an indemnity year, there is no refund of any part of the premium for the existing policy, which must run its course before the six-year run-off policy commences (at the start of the next indemnity year in October).

After the initial six years of run-off, legal practices are covered for run-off liability by the Solicitors Indemnity Fund, at no additional charge.

It may be necessary to sue clients who will not pay their bills and with whom compromises cannot be achieved. Those clients may raise issues that require a trial - at great expense - to resolve them, imposing the risk of adverse costs orders on the already beleaguered partners. There will also be ongoing administrative costs, such as accountancy and storage (of files).

If the partners cannot agree among themselves as to how to conduct the winding-up, or if there are concerns about misappropriation of assets by certain partners, then one or more partners can seek (and will normally be granted) the appointment of a receiver. The receiver has to be paid out of the assets of the firm or, if those are insufficient, by the partners themselves.

In a dispute between partners, each partner will have to bear his own legal, and possibly accountancy, costs. As the recent decision in Sahota v Sahota (2006) EWHC 344 (Ch) shows, even complete success in a dissolution action does not in all cases guarantee reasonable recovery of costs incurred.

There is no ongoing stream of income to pay for these outgoings. The partners have to meet them out of their net income from their new firms.

One or more partners may fall on hard times, or may simply refuse to contribute, thus requiring the remaining partners to make good the share of the partner(s) concerned in any shortfall, possibly with no real prospect of repayment and/or with the added burden of having to sue the partner(s) concerned for contribution. Sometimes partners die during the winding-up period, adding to the complications.

Law firm winding-up can last typically 15 or more years, if only to accommodate the long-stop limitation period for negligence claims under section 14B of the Limitation Act 1980 (during which time a dissolved firm may wish to maintain a reserve against the possibility of having to pay policy excesses). In reality, there can never be any certainty that no further liabilities will emerge, or that limitation will provide a complete defence. But after a decade and a half, pragmatism tends to prevail, and a final distribution of the reserve may be made.

The day when all ledger balances have been reduced to zero, with at least no known contingent liabilities, so that the winding-up can to all intents and purposes be declared complete, is truly one to celebrate.

Peter Garry, Cripps Harries Hall, Kent